The Economy Wide Benefits of Increasing the Proportion of Students Achieving Year 12 Equivalent Education

Transcription

1 January 2003 A Report prepared for the Business Council of Australia by The Economy Wide Benefits of Increasing the Proportion of Students Achieving Year 12 Equivalent Education Modelling Results

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3 The Allen Consulting Group Pty Ltd ACN Sydney 3rd Floor, Fairfax House, 19 Pitt St Sydney New South Wales 2000 Telephone: (61 2) Facsimile: (61 2) Melbourne 4th Floor, 128 Exhibition St Melbourne Victoria 3000 Telephone: (61 3) Facsimile: (61 3) Canberra Level 12, 15 London Circuit Canberra ACT 2600 Telephone: (61 2) Facsimile: (61 2) Perth Level 25, 44 St Georges Terrace Perth WA 6000 Telephone: (61 8) Facsimile: (61 8) Online Website:

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5 Table of Contents 1. Introduction 1 2. Modelling Assumptions 2 3. Key Results 3 4. Conclusions 7 Attachment A: MONASH Modelling Report 9

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7 1. Introduction The Business Council of Australia (BCA) commissioned the Allen Consulting Group and the Centre of Policy Studies at Monash University to undertake an analysis of the economy wide benefits of an increase in the proportion of Australian students achieving Year 12 equivalent education. This report provides a brief summary of the key results. The full modelling report provided by the Centre of Policy Studies is at Attachment A. The background for this modelling work is contained in two reports. The first is Young Persons Education, Training and Employment Outcomes with Special Reference to Early School Leavers which was prepared by Applied Economics for the BCA and the Dusseldorp Skills Forum (DSF) in October The second report titled Realising Australia s Commitment to Young People was prepared for the DSF by Applied Economics in November That report examined the impact of a ram that would result in an increase from 80 to 90 per cent in the proportion of young people who achieve Year 12 equivalent education in the five year cohort 2003 to The report concluded that the benefits of such a ram would be significant the net present value of the ram was estimated to be around $8.2 billion with a discount rate of 5 per cent, or around $4.6 million discounted at 7 per cent. The work undertaken by Applied Economics essentially examined the direct costs and benefits of a ram that increased Year 12 equivalent education for the single 2003 to 2007 age cohort. This current modelling exercise By the Centre of Policy Studies at Monash University expands on this earlier work by: incorporating the indirect costs and benefits of a ram to expand the proportion of students completing Year 12 equivalent education (for example, changes in employment and taxation revenue arising from the ram); and modelling an on going (rather than a one off) ram to increase the proportion of students completing Year 12 equivalent education we believe this is a more realistic policy scenario than one in which the ram ceases after five years. The specification of the modelling task is outlined in Exhibit 1. 1

8 Exhibit 1 THE MODELLING TASK The MONASH macroeconomic model was used to examine the impact of implementing a ram ( the ram ) to increase the proportion of young people in Australia who achieve a Year 12 or equivalent education from 80 to 90 per cent. As reported by Applied Economics in Young Persons Education, Training and Employment Outcomes With Special Reference to Early School Leavers (prepared for the BCA and DSF in October 2002), this increase represents 50 per cent of early school leavers. The ram consists of a government funded increase in the provision of education and training, including apprenticeships and traineeships and transition rams. The modelling exercise assumes that the ram is implemented in 2004 and continues until the end of the forecast period in The costs associated with the ram include the costs of extra school places; extra apprenticeships and traineeships; extra school books and uniforms; and lost earnings for ex early school leavers during their extra school years. Benefits include increased earnings for ex early school leavers once their extra school years are completed; improved social outcomes (e.g. reduced crime); and gains for employers (e.g. increased productivity and profitability). The modelling exercise was required to determine the impact of the implementation of the ram on key macroeconomic indicators such as GDP and the terms of trade. The net impact of the ram on economic welfare over the forecast period was also examined. 2. Modelling Assumptions The modelling was undertaken using the MONASH macroeconomic model (detail on the model is included in Attachment A). The key assumptions underlying the modelling are that: the direct costs and benefits of extra Year 12 equivalent education are as estimated by Applied Economics in Realising Australia s Commitment to Young People; as a result of the ram, there is a fall in earnings for workers who have not participated in the ram equal to 10 per cent of the extra earnings generated by the ram this is referred to as the displacement rate ; Australia s population grows by 1 per cent per annum; wages grow annually by 1.3 per cent and long run annual employment grows by 1 per cent; and the ratio of public sector deficit to GDP remains unchanged by the policy this means that taxes are adjusted in line with the government costs and benefits associated with the ram. In the early years of the ram taxes rise to fund the ram, while in later years, taxes fall in response to increased economic activity. 2

9 3. Key Results The key results of the modelling are that: the ram will reduce GDP between 2004 and 2014 (relative to business-as usual), but increase it in the longer run by 2020, GDP is estimated to be 0.28 per cent higher than would otherwise have been the case; the ram will reduce real private consumption between 2004 and 2011 (relative to business-as usual), but increase it in the longer run by 2020, consumption is estimated to be 0.18 per cent higher than would otherwise have been the case; and the ram will have a positive long term impact on economic welfare using a discount rate of 5 per cent, the ram will generate a stream of welfare benefits between equivalent to a one off increase in welfare in 2003 of around 2.5 per cent. In dollar terms, this equates to a one off increase in consumption in 2003 of around $10.7 billion. Macroeconomic modelling generally involves estimating the impact of a proposed policy by applying a series of policy shocks to a business as usual forecast of future economic outcomes. Deviations from the business as usual forecast generated by the policy shocks then provide an indication of the impact of the policy on key macroeconomic indicators. In this case, the policy shocks applied to the MONASH model s business as usual forecasts (or base case ) comprised the direct costs and benefits associated with the ram in each year of the forecast period ( ). In interpreting the results of the MONASH model it is critical to note that all results are therefore shown relative to outcomes under the base case (business as usual) projection. Where, for example, the ram is estimated to lead to an estimated decline of GDP of 0.6 per cent, this means that GDP is 0.6 per cent below the level it would have been under the business as usual case. It does not mean that the rate of growth is 0.6 per cent lower. GDP Initially, the ram reduces GDP relative to business as usual (Exhibit 2). This is mainly due to the withdrawal of labour associated with the increased participation by young people in education. In the early years of the ram, tax increases are also needed in order to fund the costs of delivering the additional education services required by ram. Over time however, the ram acts to increase GDP relative to its business as usual level. These increases are largely due to an eventual increase in labour input to the economy, mainly reflecting increased efficiency and participation by ram graduates. By 2020, GDP is 0.28 per cent greater than would have been the case in the absence of the ram. An increase of 0.28 per cent in Australia s current GDP would be worth about $1.8 billion. 3

10 Exhibit 2 GDP AND CONSUMPTION 2004:2020 % deviations over business as usual GDP Private consumption Source: MONASH modelling results Real Private Consumption In the short run, real private consumption is reduced below business as usual levels (Exhibit 2). As with GDP, this is due largely to the reduction in labour input, as well as tax increases generated by the ram. However by 2020, the ram has resulted in an increase in economic activity and a corresponding fall in taxation (in order to leave the public sector deficit to GDP ratio unchanged) as a result, consumption is 0.18 per cent higher than would have been the case without the ram. An increase of 0.18 per cent in Australia s current level of real private consumption would be worth about $720 million. Welfare Benefits to 2050 For the purposes of analysing the welfare impacts of a ram to increase the proportion of young people completing Year 12 equivalent education, changes in private consumption generated by the MONASH model provide a reasonable measure of the economy wide welfare effects of the ram. The long term welfare impacts of the ram can therefore be identified using estimates of the impact of the ram on real private consumption between 2004 and

11 In its current form, MONASH is only set up for modelling simulations out to the year However, given that the policy under examination in this report clearly has benefits beyond this time, it is helpful to attempt to generate an estimate of the longer term impacts of the ram from the existing modelling results. Analysis of the modelling results showed that the real private consumption results generated by MONASH are tightly correlated with the direct benefits of the ram, as identified by Applied Economics. In order to estimate the impact of the ram beyond 2020, it is therefore possible to extrapolate the consumption results out to 2050 using the direct benefit data as a base. These extrapolated results are shown in Exhibit 3 the Centre of Policy Studies is confident that had they been able to extend the MONASH simulation out to 2050, the MONASH results for private consumption would have been close to those shown in Exhibit 3. According to Exhibit 3, real private consumption would be around 1 per cent higher in 2050 than would otherwise have been the case as a result of the ram. Exhibit 3 REAL PRIVATE CONSUMPTION FOLLOWING THE PROGRAM: % deviations over business as usual consumption direct benefits extrapolation Source: MONASH modelling results Using the data in Exhibit 3, Exhibit 4 below shows for varying discount rates the variation in household consumption in 2003 that would have an equivalent welfare effect to the variation in household consumption caused by the policy for the period 2004 to The calculations in Exhibit 4 are therefore broadly equivalent to net present value calculations in welfare terms for the ram. For example, using a discount rate of 5 per cent, the ram is estimated to generate a stream of welfare benefits between equivalent to a one off increase in welfare in 2003 of around 2.5 per cent. In dollar terms, this equates to an increase in consumption in 2003 of around $10.7 billion. 5

12 As can be seen from Exhibit 4, the ram generates positive benefits for all discount rates below 9.6 per cent this is therefore approximately the internal rate of return on the ram. Exhibit 4 CALCULATION OF WELFARE EFFECT OF PROGRAM Discount rate Equivalent % deviation in household consumption in Equivalent $ deviation in household consumption in 2003 ($ billion) The MONASH forecat for real private consumption in 2003 is $415 billion Source: MONASH modelling results These welfare benefits accrue disproportionately to ram participants, although all Australians benefit from reduced tax rates in the later years of the ram 1. The impact on public sector finances is, by assumption, neutral. Sensitivity Analysis In order to test the sensitivity of the results to the assumption that the displacement rate for the earnings of non participants in the ram is 10 per cent, the model was also run using a displacement rate assumption of 30 per cent 2. The results show that the increase in the displacement rate delays the benefits of the ram by a number of years, and reduces the gain to consumption from around 1 per cent over business as usual levels in 2050 to around 0.8 per cent. Exhibit 5 below shows the welfare effects of the ram under the pessimistic displacement rate assumption. The pessimistic displacement rate assumption reduces the internal rate of return on the ram from around 9.6 per cent to around 7.8 per cent. Exhibit 5 CALCULATION OF WELFARE EFFECT OF PROGRAM: PESSIMISTIC DISPLACEMENT RATE ASSUMPTION Discount rate Equivalent % deviation in household consumption in Equivalent $ deviation in household consumption in 2003 ($ billion) Source: MONASH modelling results 6 1 The modelling undertaken for this exercise does not quantify the relative benefits accruing to ram participants and non participants. Further modelling would be required to estimate these impacts. 2 As assumption that the displacement rate was equal to 20 per cent would produce results roughly half way between those obtained in relation to the 10 and 30 per cent assumptions respectively.

13 Consistency with Earlier Results As noted earlier, Applied Economics concluded that an education and training ram that increased the proportion of young people achieving Year 12 equivalent education from 80 to 90 per cent for the five year cohort 2003 to 2007 would have a net present value of around $8.2 billion using a discount rate of 5 per cent, or $4.6 million discounted at 7 per cent. It is not possible to make a direct comparison between the Applied Economics results and those obtained by the MONASH model in this exercise. There are a number of minor differences between the two analyses, in particular that Applied Economics: model the ram for a five year cohort, while the current analysis examines an on going policy; explicitly include benefits to employers arising from the ram while these are derived endogenously in MONASH; include benefits accruing from the ram after 2050 in calculating the NPV of the ram; and define welfare gains in absolute terms rather than on a per capita basis as in MONASH (this means that fixed welfare gains arising from the ram become less valuable in MONASH over time as the population grows). Appendix 1 in Attachment A presents an analysis that attempts to address the above issues to derive comparable NPV figures from the Applied Economics and the MONASH results. This analysis shows that, if benefits beyond 2050 are included and the ram is implemented on an on going (rather than one off) basis, MONASH estimates of the NPV of the ram are around $19 billion, while the Applied Economics equivalent result is around $23 billion. Given the minor differences between the two approaches used, the two results are, on balance, broadly consistent. (The remaining difference is likely to be due largely to the general equilibrium effects underlying the MONASH analysis.) 4. Conclusions A ram to increase the proportion of young people who achieve a Year 12 equivalent education from 80 to 90 per cent requires an investment in the short term initially, participation in the ram results in less labour input to the economy, and taxes are increased to finance extra provision of education services. As a result, following the implementation of the ram, GDP falls relative to business as usual levels between 2004 and 2014, and private consumption falls relative to business as usual levels between 2004 and In the longer run however, the benefits of the ram outweigh its costs. Over time, labour inputs increase and taxes fall as a result of the additional economic activity generated by the ram. In 2020, GDP is 0.28 per cent (or around $1.8 billion in today s terms) greater than would otherwise have been the case. In terms of welfare, MONASH modelling results show that the policy will generate a rate of return of around 9.6 per cent over the period 2004 to While these benefits accrue disproportionately to ram participants, in the ram s later years, all Australians benefit from lower taxes as a result of the ram. The impact on public sector finances is, by assumption, neutral. 7

14 The short term investment required to generate longer term benefits from the ram is therefore a one off net cost once the ram has been in place for some years, its on going net benefit/cost impact is substantially positive. This one off short term cost could be viewed as a cost made necessary today by past inaction to improve educational achievement had achievement levels been higher in past years, it is possible that the economy could already be reaping the benefits generated when a higher proportion of young people complete Year 12 equivalent education. These results are sensitive to the assumption made about the rate at which extra earnings generated for ram participants displace the earnings of other workers as the displacement rate increases, the long term increases in GDP and private consumption brought about by the ram are reduced, and the rate of return to the ram between falls. Nevertheless, even at relatively higher displacement rates, the long term economic impact of the ram is positive. It is also important to note that the improvement in education achievement rates embodied in the ram modelled in this exercise is substantial an increase in the proportion of young people completing Year 12 equivalent education to 90 per cent represents a significant increase in relation to current achievement levels. A ram which aimed to increase Year 12 equivalent education by a relatively smaller proportion, or which staggered the increase in achievement rates over time, may have relatively lower economic costs in the short term. Conversely, the long term economic benefits arising from such a ram may also be relatively reduced. 8

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17 ATTACHMENT A The economy-wide benefits of an increase in the proportion of students achieving year 12 equivalent education by Peter B. Dixon and Maureen T. Rimmer Centre of Policy Studies 15 January, Introduction Table 1 is taken from a report entitled Realising Australia s Commitment to Young People prepared for the Dusseldorp Skills Forum by Applied Economics, November 2002 (hereafter the AE report). 3 The table shows costs and benefits of a ram outlined in the AE report which would result in an increase from 80 per cent to 90 per cent in the proportion of young people who achieve Year 12 equivalent education. Our objective is to subject the AE education and training ram ( the AE ram ) 4 to a macroeconomic analysis. We do this by translating the ram into shocks to be applied to the MONASH model 5 and then conducting simulations showing deviations from business-as-usual forecasts caused by these shocks. The paper is organised as follows. In section 2 we interpret the AE numbers in Table 1. In section 3 we convert the AE ram from a once-off policy dealing with a single five-year cohort of potential early school leavers into an ongoing policy through to In section 4 we report our central MONASH simulation of the effects of the ongoing policy. Section 5 reports a 3 We thank the principal author of the AE report, Peter Abelson, for taking time to answer our queries concerning the report. He is, of course, not responsible for any misinterpretations that we may have made. 4 The AE report incorporated a package of labour market rams (LMPs) to supplement the proposed education and training ram the LMPs are not considered in this modelling exercise. 5 A brief description of MONASH is in Appendix 2. 9

18 Table 1. Direct effects of providing further school-level education to the 2003 to 2007 cohort ($m, 2002 prices) * Present value in 2011 of incomes from 2011 to 2050 Costs of ram ,578 1 Costs to government (a) 2 Expenditures by students (b) 3 Total cost Benefits of ram 4 Net earnings of students (c) 5 Social benefits (d) ,715 6 Displacement (e) ,358 7 Total benefits (f) ,935 * This is a condensed version of AE s Table S1. (a ) This includes the costs of extra school places, extra apprenticeships and traineeships, and extra transition rams. (b) This includes items such as school books and uniforms. (c) Increase in earnings less earnings foregone during study. (d) This covers better social behaviour associated with higher educational achievement. For example, AE quote research showing that people with Year 12 education are less likely to commit crimes than those without Year 12 education. (e) This allows for displacement by ram participants of other workers. AE assume that the earnings of people who do not participate in the ram will be reduced by 10 per cent of the extra earnings of those who do participate in the ram. Thus, the number in the 6 th row of the final column is -1/10 times the number in the 4 th row. In section 5, we increase displacement from 10 per cent to 30 per cent. In terms of Table 1, we multiply the numbers in row 6 by three. (f) AE included an extra (relatively minor) benefit entitled Benefits to employers. This covered extra profitability associated with employing better educated higher productivity workers. We have left this out of our analysis because the MONASH model, that we will be using in sections 4 and 5 to analyse the ram, deals with this issue endogenously. sensitivity simulation. We adopt less optimistic assumptions than that in the central case for the effects of additional education for young people on employment opportunities and wages of other people. Concluding remarks are in section 6. 10

19 2. Interpretation of Table 1: costs and benefits of an increase in the proportion of students achieving Year 12 equivalent education, estimates for the 2003 to 2007 cohort To understand the pattern of the figures across the years in Table 1, it is necessary to understand the timing of the AE ram. The figures refer to costs and benefits of a ram that targets young people who, in the absence of the ram, would have completed their education at Years 9, 10 and 11 in each of the 5 years from 2003 to Costs In 2004 the ram is directed at potential early school leavers at the end of 2003 and costs $344 million. In 2005 the ram is directed at potential early school leavers at the end of 2004 but also involves expenses associated with the continuing education of some of the students captured by the ram at the end of 2003 (those who would have left school at the end of 2003 having completed only Year 9 or 10). Thus, costs associated with the ram in 2005 ($558 million) are greater than those in 2004 ($344 million). In 2006 the ram is directed at potential early school leavers at the end of 2005 but also involves expenses associated with the continuing students captured by the ram at the end of 2003 and the end of Thus, again we see an increase in costs ($649 million in 2006 compared with $558 million in the previous year). In 2007 the ram is directed at potential early school leavers at the end of 2006 but also involves expenses associated with continuing students captured at the end of 2004 and the end By 2007, it is assumed that students from the end of 2003 would have completed their participation in the ram. Thus, the cost of the ram in 2007 is about the same as that in Similarly, the cost of the ram in 2008 is about the same as that in By 2009, the ram is trailing off, with costs falling to $307 million. In 2009 the ram is concerned only with continuing students captured at the end of 2006 and the end of In 2010, the ram is concerned only with continuing students captured at the end of 2007, and costs fall to $81 million. Beyond 2010, the AE ram is finished and there are no further expenses. Benefits In 2004, the ram reduces the wages received by young people by $181 million. This is the reduced earnings in 2004 of potential early school leavers captured by the ram at the end of In 2005, the ram reduces the wages received by young people by $367 million. This is the reduced earnings in 2005 of potential early school leavers captured at the end of 2004 and also of those continuing in the ram from the end of The 2005 number ($367 million) includes an offset for the ram-related increase in wage rates and workforce participation by students who complete the ram at the end of In 2006 the net reduction in student earnings peaks 11

20 at $362 million. This figure is a combination of earnings losses by students captured at the end of 2005 and by those continuing in the ram from the end of 2003 and the end of Offsets from increased earnings by students completing the ram in 2004 and 2005 are taken into account. In 2007 and 2008 offsets become increasingly important as the number of graduates from the ram, with increased wage and participation rates, swells. By 2009 and 2010 there are few students left in the ram. Thus, as a group, the students who at any stage participated in the ram have higher earnings than they would have had in the absence of the ram. Beyond 2010, there are no students suffering reduced employment due to continued studies. For the group of students who participated in the ram, AE estimate that the present value in 2011 of the ram-related increase in their earnings is $13,578 million. 3. Translating the single cohort estimates into estimates for an ongoing ram AE analyse a single ram focused on the cohort of early school leavers in 2003 to We think it is more realistic to look at an ongoing policy. If a ram were implemented that raised the proportion of Year 12 completers from 80 per cent to 90 per cent then it seems unlikely that it would be abandoned when it had finished dealing with early school leavers from In translating the AE estimates for a single cohort ram into estimates for an ongoing policy we constructed Tables 2 to 5. In Table 2 the ram A column refers to rows 4 and 6 of Table 1. It shows the net earnings of students in the AE ram adjusted for displacement for each of the years 2004 to For the years beyond 2010, we take the annual net earnings adjusted for displacement as $678m. This is consistent with the present value numbers in the final column of rows 4 and 6 in Table 1. 6 The B column in Table 2 refers to a new AE ram directed at potential early school leavers from the end of 2008 to the end of Program B is the same as ram A except that it is scaled up by the factor ( = ) to allow for 1 per cent annual population growth over the five years between the commencements of the two rams. Similarly, columns C to J of Table 2 refer to new AE rams directed at potential early school leavers from the years 2014 to 2018, 2019 to 2023, etc. The TOTAL column in Table 2 is the sum across rams A to J. It shows for each year net earnings adjusted for displacement for all the rams, that is it shows adjusted net earnings from the ongoing policy. In the with wage growth column, we have 6 AE used a discount rate of 5 per cent: t 2050 t 2011 t / (1.05 ) =

21 A Table 2. Net extra earnings from ongoing policy ($m, 2002 prices) B C D E F G H I J TOTAL with wage growth % of total wages The ram A column refers to rows 4 and 6 of Table 1. The B column refers to a new AE ram directed at potential early school leavers from the end of 2008 to the end of Program B is the same as ram A except that it is scaled up by the factor ( = ) to allow for 1 per cent annual population growth over the five years between the commencements of the two rams. Similarly, columns C to J refer to new AE rams directed at potential early school leavers from the years 2014 to 2018, 2019 to 2023, etc. The TOTAL column is the sum across rams A to J. In the with wage growth column, we have introduced 1.3 per cent annual growth in real wage rates and applied this growth rate to the TOTAL column. In the final column we have expressed the with wage growth column as a per cent of our basecase forecast of Australia s wage bill in 2002 prices. 13

22 A B C Table 3. Costs of ongoing policy ($m, 2002 prices) D E F Prog G H I J TOTAL with wage growth % of total wages Table 3 was constructed in a similar way to Table 2. Table 3 refers to row 3 of Table 1. 14

23 A B Table 4. Social benefits of ongoing policy ($m, 2002 prices) C D E F Prog G H I J TOTAL with wage growth % of total wages Table 4 was constructed in a similar way to Table 2. Table 4 refers to row 5 of Table 1. The social benefits associated with the ram covers better social behaviour associated with higher educational achievement. e.g. reduced crime. 15

24 A B Table 5. Total net benefits of ongoing policy ($m, 2002 prices) C D E F G H I J TOTAL with wage growth % of total wages Table 5 is Table 2 minus Table 3 plus Table 4. 16

25 introduced 1.3 per cent annual growth in real wage rates and applied this growth rate to the TOTAL column. A trend growth in real wages of 1.3 per cent is a reasonable forecast in light of the performance of the Australian economy over the last 30 years. In the final column of Table 2 we have expressed the with wage growth column as a per cent of our basecase forecast of Australia s wage bill in 2002 prices. In making the forecast we assumed longrun annual employment growth of 1 per cent (as well as real wage growth of 1.3 per cent). As can be seen from the final column of Table 2, an ongoing AE policy is projected to generate increased net earnings by 2050 equivalent to an increase in labour input of per cent. Tables 3 and 4 were constructed in a similar way to Table 2. Table 3 refers to row 3 of Table 1 and Table 4 refers to row 5. Table 5 is Table 2 minus Table 3 plus Table 4. The final column in Table 5 shows the total direct net benefits of the ongoing policy as a per cent of total wages. In 2004 the ongoing policy is equivalent to a loss of total labour input to the economy of per cent. The ongoing policy continues to generate small losses to the economy until Beyond 2014, the ongoing policy generates an ever increasing gain to the economy, rising to the equivalent of a per cent increase in labour input in The gain to the economy increases steadily reflecting the ever increasing proportion of the workforce up to 2050 that are graduates from rams A to J. While we have not taken the numerical analysis beyond 2050, it is clear that the gains to the economy would eventually stabilise as participants from early rams retire. 4. Monash simulation, central case This section contains results from a simulation with the MONASH model of the macroeconomic effects of the implementing the ongoing policy specified in Tables 2 to 4. In subsection 4.1 we list the key assumptions underlying the simulation and in subsection 4.2 we present results for our central simulation. In its current form MONASH is set up for simulations out to the year This is a disadvantage in the current context where the policy has significant effects well beyond However, as we will see in subsection 4.3, the simulation results up to 2020 are strongly suggestive of those that would be achieved if the model were extended, for example, to Key assumptions Public expenditure and taxes We assume that the ongoing policy makes no difference to the path of real public consumption of all goods and services except education. Government provision of education 17

26 services [which include all of the services listed in note (a) to Table 1] increases in accordance with the costs identified in Table 3. Tax rates on labour and capital are adjusted to leave the ratio of the public sector deficit to GDP unchanged by the ongoing policy. Under AE assumptions a small share of the direct costs (largely school books and uniforms) in Table 3 should be borne by participating students. We ignore this complication. In effect we assume that the government buys the students books and uniforms and that the private sector pays for these via taxes. Rates of return on capital In simulations of the effects of changes in policy and other exogenous variables, MONASH allows for short-run divergences in after-tax rates of return on industry capital stocks from their levels in the basecase forecasts. Short-run increases/decreases in rates of return cause increases/decreases in investment and capital stocks, thereby gradually eroding the initial divergences in after-tax rates of return. A feature of the ongoing policy is that the capital/rate-ofreturn adjustment is far from completed in our simulation period (2004 to 2020). Because the shocks introduced in our simulation are eventually favourable, rates of return are elevated at the end of the simulation period. Production technologies MONASH contains variables describing: primary-factor and intermediate-input-saving technical change in current production; input-saving technical change in capital creation; and inputsaving technical change in the provision of margin services. In the simulations described in this paper, all of these variables are exogenous. We move a variable representing general labour-saving technical change away from its forecast path to introduce the social benefits (Table 4) of the ongoing policy. In other words, we represent the direct benefits of reductions in crime and other social improvements associated with the policy as a reduction in the amount of labour required to support any given level of output. Labour market We assume that wages rates adjust to ensure that in the long run employment will absorb an exogenously given share of the available effective supply of labour. Under the ongoing policy, there are changes in the effective supply of labour reflecting: withdrawal of students into additional study; increased workforce participation of graduates from the on-growing ram; and increased effectiveness of graduates. These changes in effective supply (for our central case) are summarised 18

27 in the final column of Table 2. Because of assumed stickiness in real after-tax wage rates, adjustments to changes in effective labour supply are not instantaneous. However, eventually an x per cent increase in effective labour supply leads to an x per cent increase in employment of effective labour units. This assumption is consistent with conventional macro-economic modelling in which the NAIRU 7 is exogenous MONASH results: central simulation Charts 1 to 5 show MONASH results as percentage deviations from basecase forecasts. Highlights of the results include the following. With the ongoing policy, real GDP in 2020 is increased by 0.28 per cent (Chart 1). An increase of 0.28 per cent in Australia s current GDP would be worth about $1.82 billion. The increase in GDP in 2020 arises from a combination of three factors. The first is the effective increase in labour input (0.33 per cent), mainly reflecting increased efficiency and participation by ram graduates. With labour contributing about 65 per cent of GDP, the effective increase in labour input explains an increase in GDP of 0.21 per cent ( = 0.65*0.33). The second factor is the general increase in productivity reflecting the social benefit. As can be seen in Chart 1, by 2020 this is worth about 0.05 per cent of GDP. The third factor is the increase in capital. By 2020 the capital stock is about 0.05 per cent higher with the ongoing policy than it otherwise would have been. With capital contributing about 35 per cent of GDP, the increase in capital explains an increase in GDP of 0.02 per cent ( = 0.35*0.05). Initially, the ongoing policy reduces GDP (Chart 1). For example, in 2006 GDP is down by 0.15 per cent mainly as a result of the withdrawal of labour associated with increased participation by young people in education (Table 2). However, the short-run reduction in effective labour input also reflects our sticky-wage assumption. In the early years of the ongoing policy there are significant tax increases. These cause short-run increases in real before-tax wage rates (recall that we assume real after-tax wage stickiness). Increases in real before-tax wages reduce employment. They also reduce rates of return on capital and consequently cause reductions in investment (Chart 2). The reductions in investment explain the short-run reductions in capital (Chart 1). Another factor contributing to the short-run reduction in capital is the shift in national expenditure towards education, a highly labourintensive activity. Eventually the capital stock recovers as wages adjust and effective labour supply increases. 7 NAIRU is the Non-Accelerating Inflation Rate of Unemployment. 19

28 By 2020, real private consumption is increased by 0.18 per cent (Chart 2). An increase of 0.18 per cent in Australia s current level of real private consumption would be worth about $0.72 billion. The increase in consumption is a reflection of increased real disposable income arising mainly from increased effective labour input. In the short run, real private consumption is reduced. In 2006 the reduction is 0.25 per cent (about $1 billion). This is explained by two factors: the reduction in effective labour input; and tax increases imposed by the government to finance increased expenditures on education. In combination, the short-run percentage movements in investment, private consumption and public consumption approximately match the short-run movement in GDP. Thus, there is little short-run movement in the balance of trade (Chart 3). Imports fall because of falls in private consumption and investment. The increase in public consumption provides only small stimulation to imports. Public consumption of education services is almost entirely domestically sourced. With imports falling and trade balanced exports must fall. This is facilitated by real appreciation (Chart 4). With reduced exports there is an increase in the terms of trade (Chart 5). In the longer term, the increases in private consumption and investment (Chart 2) generate increases in imports (Chart 3). This causes a downward adjustment in the real exchange rate (Chart 4) allowing an increase in exports (Chart 3). Corresponding to the increase in exports there is a reduction in the terms of trade (Chart 5) Extending MONASH results to 2050 and beyond: the present value of the ongoing policy in the central case As mentioned in section 3, the last column of Table 5 provides a measure for each year of the direct benefits of the ongoing ram. In Chart 6 we have plotted these direct benefits as a share of private consumption rather than of the wage bill. 8 Chart 6 also contains the MONASH results for private consumption for 2004 to As can be seen from the chart, the MONASH consumption results are highly correlated with the direct benefits. On investigation we found that the MONASH graph for private consumption lies slightly below the graph for direct benefits because the ongoing policy raises returns to capital, thereby transferring some of the benefits of the 8 Because private consumption and the wage bill are similar in magnitude, the direct benefit values plotted in Chart 6 are very similar to the numbers in Table 5. 20

29 policy to foreign owners of Australian capital. Exploiting the tight relationship between the direct benefit graph and the MONASH consumption results, we have extrapolated the consumption results out to We are confident that had we been able to extend the MONASH simulation to 2050 then the MONASH results for private consumption would have been close to the extrapolated results shown in Chart 6. Beyond 2050 we would expect the private consumption deviation to stabilise at about the 2050 level. As mentioned in section 3, the policy would mature by 2050 with the number of retirees from early rams roughly matching graduates entering the workforce from later rams. In the present context, deviations in private consumption provide a reasonable measure of the economy-wide welfare effects in each year of the ongoing policy. However, it is not clear how these annual deviations should be added to form an overall indicator of whether the policy generates net benefits or losses. Here we will assume that it is appropriate for policy makers to discount percentage increases in household consumption in future years at the percentage rate r, that is they assess the present value of an x per cent increase in household consumption taking place in t years time as x/[(1+r/100) t ]. In Table 6 we have applied this idea to the MONASH and extrapolated results for private consumption for the period 2004 to 2050 (the results used in Chart 6). 9 We have also supplied calculations for the period 2004 to infinity, assuming that beyond 2050 the consumption deviation remains at the 2050 level. For a series of discount rates we have calculated the variation in household consumption in 2003 that would have an equivalent welfare effect to the variations in household consumption caused by the policy for the period 2004 to 2050 and for the period 2004 to infinity. As can be seen from Table 6, if we ignore benefits beyond 2050, then the ongoing policy generates positive benefits for discount rates below 9.654, that is the internal rate of return for the policy is per cent. If we include benefits beyond 2050,then the internal rate of return is per cent. Table 6. Calculation of welfare effect of ongoing policy, central case Discount rate (r) Equivalent percentage deviation in household consumption in 2003, ignoring benefits beyond 2050 Equivalent percentage deviation in household consumption in 2003, AE also provides some present value calculations. A comparison of our calculations with theirs is provided in Appendix 1. 21